For Another View of Whether Stocks Are Overvalued, Keep An Eye On Debt, Balance-Sheet Leverage

Posted on July 11, 2017

For the past few months, investors have heard a lot of talk about how overvalued U.S. stocks are compared to projected corporate earning.

If those views haven’t deferred you from being in the market that’s probably a good thing, as the Standard & Poor’s 500 index is up 9.9% year-to-date through June 20.

The S&P 500 P/E Forward Estimate, a 12-month forward price to earnings ratio based on analysts’ future operating earnings projections and the index’s current price, is currently at about 18.75, according to estimates from Birinyi Associates.1

But if you want another take on whether or not stocks are overvalued, consider what’s happening with company balance sheets and credit markets. Measures of leverage, cash flow to cover interest payments on debt, and market pricing for corporate risk are signaling that we’re well into the mature phase of a typical credit cycle.

The median net leverage of S&P 500 companies as measured by the ratio of net debt to EBIDTA or earnings before interest, depreciation, taxes and amortization, has doubled since 2010, according to information compiled by the International Monetary Fund.2 As of year-end 2016, the ratio stood at 1.5 times EBITDA, and is even higher than it was at the height of the 2008 financial crisis. Perhaps, more telling, the ratio is also near the 1.6 times EBITDA it reached in 2001 when the U.S. economy was in recession from March through November.

Even as U.S. companies enjoy low borrowing costs, thanks to measures in recent years by global central banks to keep interest rates low to boost economic growth, the proportion of income to service debt and the ratio of incoming cash that’s used to pay down debt have deteriorated. That could leave those firms with less-than-stellar balance sheets vulnerable if borrowing conditions were to tighten.

The Federal Reserve is already well underway in its cycle of tightening monetary policy. In mid-June it raised its target for the federal funds rate by 25 basis points to a range of 1.00% to 1.25%. The recent increase marked the fourth time the Federal Open Market Committee raised benchmark interest rates since the current tightening cycle began in December 2015.

Data compiled by the IMF for nearly 4,000 firms accounting for about half of the economy-wide corporate sector balance sheet shows that corporate debt service as a proportion of income is at its highest level since 2010. In addition, the debt service burden for the U.S. corporate sector has risen by roughly four percentage points during the past three years to 40.3% of income, and is at the level it reached just prior to the global financial crisis. Likewise, the average interest coverage ratio – a measure of the ability for current earnings to cover interest expenses – has fallen by more than 20% to 5.4 times.

The premium investors are willing to pay for corporate debt has yet to factor in the U.S. corporate sector’s rising leverage and weaker cash flow measures. The spread on triple-B-rated U.S. corporate debt fell to 1.49 percentage points above benchmark Treasuries as of the market close on June 21, according to Bank of America Merrill Lynch’s index that tracks these securities’ performance versus an adjusted Treasury yield curve.3 That was near levels not seen since September 2014.

2-“Global Financial Stability Report: Getting the Policy Mix Right,” The International Monetary Fund, April 2007. The IMF’s report cites its own staff estimates and a variety of other sources for compiling its data. These include: Bloomberg L.P.; the National Bureau of Economic Research; S&P Capital IQ; and Thomson Reuters Datastream. http://www.imf.org/en/publications/gfsr

Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory Service offered through BCJ Capital Management. World Equity Group, Inc. and BCJ Capital Management are independently owned and operated. BCJ Capital Management is a (SEC) registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. BCJ FG 17-502

HIGHLIGHT: BUSINESS

Categories

Categories

Find us on Facebook

About BCJ

We endeavor to provide clients with the knowledge and support necessary to have complete confidence in their financial journey. To accomplish this mission, we strive to build relationships through a culture of integrity, independence, and trust. These values not only allow us to focus on each client’s unique situation, but they allow us the freedom to offer solutions that are transparent, custom, and boundless – empowering our clients to make confident choices for their future.